Chapter 15

Revision of the Equity Portfolio

Portfolio Construction, Management, & Protection, 5e, Robert A. Strong

Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

Introduction

Portfolios need maintenance and periodic

revision:
Because the needs of the beneficiary will
change
Because the relative merits of the portfolio
components will change
To keep the portfolio in accordance with the
investment policy statement and investment
strategy
2

Active Management
versus Passive Management

An active management policy is one in

which the composition of the portfolio is
dynamic
The portfolio manager periodically changes:
The portfolio components or
The components proportion within the portfolio

A passive management strategy is one in

which the portfolio is largely left alone
3

The Managers Choices

Leave the Portfolio Alone
Rebalance the Portfolio
Asset Allocation and Rebalancing within
the Aggregate Portfolio
Rebalancing within the Equity Portion
Change the Portfolio Components
Indexing

Leave the Portfolio Alone

A buy and hold strategy means that the portfolio

manager hangs on to its original investments

Academic research shows that portfolio managers

often fail to outperform a simple buy and hold
strategy on a risk-adjusted basis
e.g., Barber and Odean show that investors who trade
the most have the lowest gross and net returns
5

Rebalance the Portfolio

Rebalancing a portfolio is the process of

periodically adjusting it to maintain the
original conditions

Constant Mix Strategy

The constant mix strategy:

Is one in which the manager makes adjustments
to maintain the relative weighting of the asset
classes within the portfolio as their prices
change
Requires the purchase of securities that have
performed poorly and the sale of securities that
have performed the best
7

Constant Mix Strategy (contd)

Example
A portfolio has a market value of $2 million. The
investment policy statement requires a target asset
allocation of 60 percent stock and 40 percent bonds.
The initial portfolio value and the portfolio value after
one quarter are shown on the next slide.

Constant Mix Strategy (contd)

Example (contd)
Date

Portfolio Value Actual Allocation

Stock

Bonds

1 Jan

$2,000,000

60%/40%

$1,200,000 $800,000

1 Apr

$2,500,000

56%/44%

$1,400,000 $1,100,000

What dollar amount of stock should the portfolio

manager buy to rebalance this portfolio? What dollar
amount of bonds should he sell?
9

Constant Mix Strategy (contd)

Example (contd)
Solution: a 60 percent/40 percent asset allocation for a
$2.5 million portfolio means the portfolio should contain
$1.5 million in stock and $1 million in bonds. Thus, the
manager should buy $100,000 worth of stock and sell
$100,000 worth of bonds.

10

Constant Proportion
Portfolio Insurance

A constant proportion portfolio

insurance (CPPI) strategy requires the
manager to invest a percentage of the
portfolio in stocks:
$ in stocks = Multiplier (Portfolio value Floor value)

11

Constant Proportion
Portfolio Insurance (contd)
Example
A portfolio has a market value of $2 million. The
investment policy statement specifies a floor value of $1.7
million and a multiplier of 2.
What is the dollar amount that should be invested in
stocks according to the CPPI strategy?

12

Constant Proportion
Portfolio Insurance (contd)
Example (contd)
Solution: $600,000 should be invested in stock:
$ in stocks = 2.0 ($2,000,000 $1,700,000)
= $600,000
If the portfolio value is $2.2 million one quarter later, with
$650,000 in stock, what is the desired equity position under
the CPPI strategy? What is the ending asset mix after
rebalancing?
13

Constant Proportion
Portfolio Insurance (contd)
Example (contd)
Solution: The desired equity position after one quarter should
be:
$ in stocks = 2.0 ($2,200,000 $1,700,000)
= $1,000,000
The portfolio manager should move $350,000 into stock. The
resulting percentage would be: $1,000,000/$2,200,000 = 45.5%
14

Relative Performance of
Constant Mix and CPPI

A constant mix strategy sells stock as it

rises

A CPPI strategy buys stock as it rises

15

Relative Performance of Constant

Mix and CPPI (contd)
In a rising market, the CPPI strategy
outperforms constant mix
In a declining market, the CPPI strategy
outperforms constant mix
In a flat market, neither strategy has an
obvious advantage
In a volatile market, the constant mix
strategy outperforms CPPI

16

Relative Performance of Constant

Mix and CPPI (contd)
The relative performance of the strategies
depends on the performance of the market
during the evaluation period
In the long run, the market will probably
rise, which favors CPPI
In the short run, the market will be volatile,
which favors constant mix

17

Rebalancing Within the

Equity Portfolio
Constant Proportion
Constant Beta Portfolio
Change the Portfolio Components
Indexing

18

Constant Proportion

A constant proportion strategy within an

equity portfolio requires maintaining the
same percentage investment in each stock
May be mitigated by avoidance of odd lot
transactions

Constant proportion rebalancing requires

selling winners and buying losers
19

Constant Proportion (contd)

Example
An investor attempts to invest approximately one third of funds in
each of the stocks. Consider the following information:
Stock

Price

Shares

Value

% of Total Portfolio

FC

22.00

400

8,800

31.15

HG

13.50

700

9,450

33.45

YH

50.00

200

10,000

35.40

$28,250

100.00

Total

20

Constant Proportion (contd)

Example (contd)
After one quarter, the portfolio values are as shown below.
Recommend specific actions to rebalance the portfolio in order to
maintain the constant proportion in each stock.
Stock

Price

Shares

Value

% of Total Portfolio

FC

20.00

400

8,000

21.92

HG

15.00

700

10,500

28.77

YH

90.00

200

18,000

49.32

$36,500

100.00

Total

21

Constant Proportion (contd)

Example (contd)
Solution: The worksheet below shows a possible revision which
requires an additional investment of $1,000:
Stock

Price

Shares

Value
Before

FC

20.00

400

8,000

Buy 200

12,000

32.00

HG

15.00

700

10,500

Buy 100

12,000

32.00

YH

90.00

200

18,000

Sell 50

13,500

36.00

$37,500

100.00

Total

$36,500

Action

Value
After

% of
Portfolio

22

Constant Beta Portfolio

A constant beta portfolio requires maintaining the

same portfolio beta
It is more likely to have requirements that beta be
within some given range
To increase or reduce the portfolio beta, the
portfolio manager can:
Reduce or increase the amount of cash in the portfolio
Purchase stocks with higher or lower betas than the
target figure
Sell high-beta stocks or low-beta stocks
Buy high-beta stocks or low-beta stocks
23

Change the
Portfolio Components
Changing the portfolio components is
another portfolio revision alternative
Events sometimes deviate from what the
manager expects:

The manager might sell an investment turned

sour
The manager might purchase a potentially
undervalued replacement security
24

Indexing

Indexing is a form of portfolio management that

attempts to mirror the performance of a market
index
e.g., the S&P 500 or the Russell 1000

Index funds eliminate concerns about

outperforming the market
The tracking error refers to the extent to which a
portfolio deviates from its intended behavior
25

Tactical Asset Allocation

What Is Tactical Asset Allocation?
How TAA Can Benefit a Portfolio
Designing a TAA Program
Caveats Regarding TAA Performance
Costs of Revision
Contributions to the Portfolio

26

Tactical Asset Allocation

Tactical asset allocation (TAA) managers:

Seek to improve the performance of their funds
by shifting the relative proportion of their
investments into and out of asset classes as the
relative prospects of those asset classes change

For example, shift to stocks if stocks are

expected to outperform bonds
27

Definition (contd)

TAA attempts to take advantage of shortterm deviations from long-term trends

The most difficult part of TAA is asset class

appraisal
The process of determining the relative merits
of the various asset classes given current
economic conditions
28

Intuitive versus
Quantitative Techniques

In the intuitive approach, decisions are based on

personal opinion and gut feeling
Suffers from hindsight bias
Portfolio managers remember the times they were correct

In the quantitative approach, managers use an

analytical assessment and a system for
implementing precise portfolio changes
e.g., use the gap between the S&P 500 dividend yield
and the average yield on AAA corporate bonds
29

Overview of the Technique

30

Policy Decisions

Policy decisions involve:

Deciding to use a TAA program in the first
place
Establishing the extent to which the program
will be employed
Determining the number of asset classes to
employ
31

Strategy

There are three alternative strategic

functions:
Static strategy maintains a static portfolio mix
Reactive strategy involves decisions based on
events that have already occurred
Anticipatory strategy involves shifting funds
before the markets move
32

How TAA Can

Benefit a Portfolio

The goal of an anticipatory strategy is to

outperform the portfolio without TAA
The potential gains to a clairvoyant manager
from TAA are enormous (see next slide)

The portfolio manager must assess return

within a risk/return framework
33

How TAA Can

Benefit a Portfolio (contd)

Source: Ensign Peak Advisors, Inc., Salt Lake City, UT 84150.

34

Designing a TAA Program

Before implementing a TAA program, a

fund manager must establish:
The normal mix
The benchmark proportion each asset class
constitutes in the portfolio

The mix (exposure) range

Specifies how much the current mix can deviate
from the normal mix
35

Designing a
TAA Program (contd)

Before implementing a TAA program, a

fund manager must establish (contd):
The swing component
The percentage of the total portfolio whose
composition by asset class may change
The key element of TAA is properly investing the
swing component

36

Efficient Market Implications

TAA programs implicitly assume it is

possible to outperform a buy-and-hold
strategy by shifting asset classes
Inconsistent with the efficient market
hypothesis

Some fund managers have good records

with TAA programs
Might be skill or luck
37

Impact of Transaction Costs

The portfolio incurs trading fees each time a

trade occurs

If the marginal gains from TAA switching

do not exceed transaction costs, the
program is not effective

38

Costs of Revision

Costs of revising a portfolio can:

Be direct dollar costs
Result from the consumption of management
time
Stem from tax liabilities
Result from unnecessary trading activity

39

Commissions

Investors pay commissions both to buy and

to sell shares

Commissions at a brokerage firm may be a

function of both:
The dollar value of the trade
The number of shares involved in the trade
40

Commissions (contd)

The commission on a trade is split between

the broker and the firm for which the broker
works
Brokers with a high level of production keep a
higher percentage than a new broker

Some brokers discount their commissions

with their more active clients
41

Commissions (contd)

Discount brokerage firms:

Offer substantially reduced commission rates
Offer few ancillary services, such as market
research or periodic newsletters

Retail commissions at a full-service firm

average about 2 percent of the trade value
42

Transfer Taxes

Transfer taxes are:

Imposed by some states on the transfer of
securities
Usually very modest
Not normally a material consideration in the
portfolio management process
43

Market Impact

The market impact of placing the trade is

the change in market price purely because
of executing the trade

Market impact is a real cost of trading

Market impact is especially pronounced for

shares with modest daily trading volume
44

Management Time

Most portfolio managers handle more than

one account

Rebalancing several dozen portfolios is

time consuming

45

Tax Implications

Individual investors and corporate clients

must pay taxes on the realized capital gains
associated with the sale of a security

Tax implications are usually not a concern

for tax-exempt organizations

46

Window Dressing

Window dressing refers to cosmetic

changes made to a portfolio near the end of
a reporting period

Portfolio managers may sell losing stocks at

the end of the period to avoid showing them
on their fund balance sheets
47

Rising Importance
of Trading Fees

Flippancy regarding commission costs is

unethical and sometimes illegal

Trading fees are receiving increased

attention because of:
Investment banking scandals
Lawsuits regarding churning
Incomplete prospectus information
48

Contributions to the Portfolio

Periodic additional contributions to the portfolio

from internal or external sources must be invested
If an account holds its securities in a street name,
dividends go to the brokerage firm holding the
securities on the clients behalf
If the portfolio manager receives the dividend
checks, there needs to be some temporary haven for
these funds until they accumulate sufficiently to
finance the purchase of more securities or until
they are paid as income to the fund beneficiary
49

When Do You Sell Stock?

Knowing when to sell a stock is a very

difficult part of investing

Behavioral evidence suggests the typical

investor sells winners too soon and keeps
losers too long

50

Rebalancing

Rebalancing can cause the portfolio

manager to sell shares even if they are not
doing poorly

Profit taking with winners is a logical

consequence of portfolio rebalancing

51

Upgrading

Investors should sell shares when their

investment potential has deteriorated to the
extent that they no longer merit a place in
the portfolio

It is difficult to take a loss, but it is worse to

let the losses grow
52

Sale of a Stock Via Stop Orders

Stop orders:
Are usually used to sell but can be used to buy
A sell stop becomes a market order to sell a set
number of shares if shares trade at the stop price
Can be used to minimize losses or to protect a
profit
53

Using Stops to Minimize Losses

Stop-loss orders can be used to minimize

losses
e.g., you bought a share for $23 and want to sell
it if it falls below $18
Place a stop-loss order at $18

54

Using Stops to Protect Profits

Stop orders can be used to protect profits

e.g., a stock you bought for $33 now trades for
$48 and you want to protect the profits at $45
If the stock retreats to $45, you lock in the profit if
you place a stop order
If the stock continues to increase, you can use a
crawling stop to increase the stop price
55

Change in Client Objectives

The clients investment objectives may

change occasionally:
e.g., a church needs to generate funds for a
renovation and changes the objective for the
endowment fund from growth of income to
income
Reduce the equity component of the portfolio

56

Change in Market Conditions

Many fund managers seek to actively time

the market

When a portfolio managers outlook

becomes bearish, he may reduce his equity
holdings

57

Buy-Outs

A firm may be making a tender offer for

one of the portfolio holdings
i.e., another firm wants to acquire the security
position

It is generally in the clients best interest to

sell the stock to the potential acquirer
58

Caprice

Portfolio managers:
Should be careful about making unnecessary
trades
Must pay attention to their experience,
intuition, and professional judgment

An experienced portfolio manager worried

about a particular holding should probably
make a change
59

Final Thoughts

Hindsight is an inappropriate perspective for

investment decision making
Everything you do as a portfolio manager must be
logically justifiable at the time you do it

Portfolio managers are torn between a desire to

protect profits or minimize further losses and the
potential for price appreciation
60